Are Ireland and Spain Just Europe's Nevada and California?

Karl Whelan
, ContributorI am an economist specialising in European macro issues.Opinions expressed by Forbes Contributors are their own.

In a thought-provoking column, leading European economist Daniel Gros argues today that criticisms of austerity in Europe are mis-placed. I am sure many people will wish to address the main points made in Daniel’s article. I want to just focus on one aspect of it.

Specifically, Daniel discusses regional differences in Europe and the US as follows:

Particular countries in Europe have seen austerity-induced depressions. But the US also has pockets of very depressed areas. For Ireland and Spain, read Nevada and California (and for Greece, read Puerto Rico). The proper comparison is thus between two continental-sized economies, both of which harbour considerable diversity.

I think there are a number of reasons why this is a poor analogy. It under-estimates the damage that austerity is doing to the euro area’s troubled states and the risks that this presents for the continued existence of the euro.

Flag of Spain

For all the similarity between the aggregate performance of the US and the euro area that Gros points out, Ireland and Spain have performed far worse than any US states. The unemployment rates in California and Nevada are 10.8 percent and 11.6 percent respectively. Ireland’s unemployment rate is 14.9 percent and Spain’s has reached almost 25 percent.

State-level GDP figures from the BEA show that the California and Nevada economies have expanded over the past two years, while Ireland and Spain stagnate or decline. I’ll leave alone the idea that Greece’s Europe’s Puerto Rico with its suggested semi-attached status.

There are good reasons why even under-performing US states have done better than Europe’s crisis economies. Reductions in federal income tax collected do not affect state budgets nor do they impact upon Federal checks coming from social security and other federal programs.

States also receive federal assistance in the US’s hybrid state-federal unemployment compensation scheme and the President Obama's stimulus act provided large amounts of special assistance to states to plug holes in their budgets. None of these stabilizing programs operate in the Euro area.

Banking problems may have contributed to the recession in both the US and the Euro area but the costs associated with these problems are being allocated quite differently in the two areas.

The US has federal deposit insurance and bank resolution schemes. In Europe, it has been each country to itself. Ireland paid over 40 percent of its GDP to recapitalise its banks while fears that Spain will end up with a similar bill are driving its sovereign bond costs to unsustainable levels.

Fears over the stability of European banks are now leading to a balkanization of the European banking sector with funds fleeing from the periphery. With private sources of credit disappearing and constant pressure from the ECB that its funding is intended to be temporary, banks in Spain and Ireland are cutting back on credit to down-size their operations, further squeezing already-challenged economies. In contrast, bank credit in the US is now increasing again. Chances are that solvent businesses and households can get a loan in California.

Finally, an important difference between US and European regions is the greater ability and willingness of Americans to move states. When California slumps, people can choose to move elsewhere for work without having to learn a new language or culture. Research has shown that this pattern of labor mobility makes an important contribution to evening out unemployment problems. Emigration of this type is far less common in Europe, making the adjustment to negative shocks that much harder.

It is important to recognize these problems because, in the absence of Euro area countries having their own exchange rate or central bank, the imposition of fiscal adjustment in Spain and Ireland is contributing to a downward negative spiral. If Europe is unwilling to consider ways of easing the fiscal adjustment in the periphery – whether it be via Euro-bonds or a “Marshall plan” to stimulate growth -- questions will remain about whether the euro can be sustained. And, at the moment, these very questions are worsening an already-serious situation.